Market Failure

Topic 8

What failure?

In general, competition gives better results than a monopoly in terms of output, price & consumer surplus

But in some cases competition does not give desirable results, and Government intervention becomes necessary.

Sources of Market Failure

Produce the wrong amounts of goods or services due to externalities or ‘spillovers’

Failure to allocate sufficient resources to the production of certain goods, called ‘public’ or ‘social’ goods

Information constraints Rent seeking & monopoly Non-market goals

Externalities (or spillovers) Definition: Costs or benefits associated with the

production or consumption of a good (or service) that flow on to 3rd parties outside the market transaction

External Costs e.g. pollution from cars, smoke from factories etc

External Benefits e.g. development of new technology can also benefit the society

as well as the firm concerned

Buyer Seller

3rd Party

External Costs or Diseconomies External cost = bf

Over allocation of resources

Qe equilibrium output

Q0 socially optimal output

Society’s loss = cbf

Conclusion: When the supply curve fails to include external costs, the equilibrium price is artificially too low and the equilibrium quantity is artificially too high (ie. there is an overallocation of resources)

Includes external costs

Excludes external costs

External Costs or Diseconomies

Policy implications: Try to internalise (or capture) external costsBan the products Impose additional duties and taxesProperty rights (eg. in the case of

environmental pollution)

P

Q

D

0

Externalcosts

St

S

TAX

Over-allocationcorrected

Q0 Qe

Correcting for External Costs

External Benefits or Economies External benefit = gk

Under allocation of resources

Qe equilibrium output

Q0 socially optimal output

Society’s loss = gkh

Policy implications:

Government produces the goods

Subsidize producers or buyers

Property rights (patents etc.)

Includes external benefits

Excludes external benefits

Correcting for External BenefitsP

Q

D

S

0

Dt

SubsidySubsidyto consumerto consumer

Under-allocationUnder-allocationcorrectedcorrected

P

Q

D

0

Subsidy toproducersincreases

supply

St

S′t

Under-allocationcorrected

Qe Q0

Correcting for External Benefits

Characteristics of Private Goods Goods that are produced through the

market system. Divisible: goods comes in units small

enough to be bought by individual buyers.

Excludable: people who are willing and able to pay the equilibrium price will consume the product, but the people

who are unable or unwilling to pay are excluded from the benefits provided by

that particular product.

Characteristics of Public Goods Goods would not be produced at all by the

market system. Indivisible: goods that cannot be divided into

“units” so that they can be sold to individual buyers.

Non- Excludable : there is no effective way of excluding individuals from the benefit available from the consumption of public goods once these goods have been produced.

Goods that have both characteristics are referred to as pure public goods.

Public Goods vs. Private Goods

Private goodsProduced through the

market system Divisible Excludable

(ie. subject to the exclusion principle)

Examples ?

Public goodsNot provided by the

market system Indivisible/joint

consumption possible

Non-excludable (ie. not subject to the exclusion principle)

– free rider problem Examples ?

Free - Rider Problem Free-Rider Problem: when people can receive

benefits from the consumption of goods and services without contributing directly to its

costs. Given the inapplicability of the exclusion

principle (free-rider problem), there is no economic incentive for private firms to supply

public goods. As a result, government has to step in to provide the good (or service) because of its

substantial social benefits

Characteristics of Quasi (near) public goods

Joint consumption is possible up to a certain capacity

Exclusion is possible Eg. public transport (bus, train travel),

museums, libraries, a football match, etc

NOTE: In some cases Public / Quasi public goods can be privately produced. In this case “public” does not mean “Government owned or made”.

Information Constraints

Consumers may not have complete information (or understanding) about some products e.g. medicines, houses, cars, TV sets etc

If the consequences of having incomplete or wrong information are severe, the Government may intervene

Interventions could be in the form of warranties, production standards, product liability etc.

Rent seeking Rent seeking involves any unproductive activity

undertaken to earn supernormal profits e.g. lobbying for quotas, market protection from imports, changes in tax/duties, monopoly rights etc.

There is a double loss: (a) resources wasted on rent seeking (b) loss because of misallocation of resources (due to the quota, tariff etc)

The Government needs to handle such situations using specific policies

Non market Goals We have always considered profit

maximisation to be the ultimate economic goal for a firm

Some activities are not driven by profit (or may not even generate any revenue) socially desirable e.g. orphanages, animal shelters, free primary

education etc.

Left to itself, the market will not produce such goods. Thus Government intervention is required.

Past Exam Question

When the market fails to operate efficiently, the government may be required to intervene. Outline the type of measures the government would be expected to take when the market failure was due to: (i) an external cost (or external diseconomy) (ii) the commodity involved being a public

good.